UPDATE 2-U.S. regulators at odds over aid for CIT Group

* FDIC clashing with other regulators over aid for CIT

* FDIC fears CIT aid involves too much risk exposure

* Treasury, Fed exploring other aid options for CIT (Recasts, adds comments from Ireland, details on bailouts)

By Karey Wutkowski

WASHINGTON, July 13 (Reuters) - The U.S. government is divided over how to handle the deteriorating condition of lender CIT Group, with the Federal Deposit Insurance Corp insisting that the lender poses too much of a risk for it to qualify for a government debt guarantee program.

The FDIC has been "very reluctant" to provide relief to lender CIT Group CIT.N through its debt guarantee program designed to provide liquidity to healthy financial firms, partly because the regulator is not satisfied with the lender's collateral, a source familiar with the matter said on Monday.

The Treasury Department and Federal Reserve have been supportive of CIT getting access to the facility, and are now exploring other aid options for the lender, the source said.

One option being considered is granting CIT's request to transfer assets to its CIT Bank unit, the source said, adding that such a move would take a lot of pressure off CIT's financial situation.

The source spoke anonymously because the government discussions have been private. An FDIC spokesman said the agency does not comment on pending applications. Spokeswomen from the Treasury and the Fed declined to comment.

CIT, which provides financing to many small and medium-sized businesses, has said it is in talks with regulators about how to improve liquidity after billions of dollars in losses have resulted in a credit crunch. [ID:nN13184030]

CIT's liquidity crunch comes at a critical time for regulators, and could send a message about the government's approach to ailing financial firms whose failure may cause pain but not bring markets to a halt.

The lender's failure would be the biggest collapse of a financial firm since regulators seized Washington Mutual Inc in September.

Oliver Ireland, an attorney at Morrison & Foerster and a former Federal Reserve Board lawyer, said CIT's troubles could derail a positive, but fragile, sentiment about the U.S. economic recovery. "If you start to see some signs of significant failures along the way, it may reverse that sentiment," he said.

A head of a large hedge fund said he was concerned that if CIT is allowed to fail, it could cause credit spreads to significantly widen again.

"Letting CIT go away does a lot to the confidence in the system," the hedge fund executive said, speaking anonymously because he was not authorized to speak publicly. "The government should act soon because you don't want a run on the bank."

But Ireland said the government must weigh numerous factors, including the impact on CIT's counterparties, the overall effect on the perception of the economic recovery, and potential political fall out among lawmakers opposed to bailouts.